Tokenized Asstes vs. High-Yield Bonds: Which is the New Way to Increase Trust While Decrease Costs?
Constantin Kurbatov – Managing Director of Bankex, would like to answer these questions.
In order to unlock the enormous potential of the asset tokenization technology and explore how it can change the financial market, one must first understand how high-yield bonds (or “high-risk” bonds) are issued today.
Unlike other kinds of obligations, high-yield bonds are issued by companies that need cash injections but do not have a long history or a solid reputation. As the name suggests, such bonds have a greater return on investment (ROI), however, they are considered to carry higher levels of risk. Investors have little trust in them because they are often based on questionable assets (or their cash flow is unpredictable). According to statistics, up to 5% of these bonds default.
How are high-yield bonds issued?
When a company decides to issue bonds to attract investments, its owners need to employ the services of an investment bank. The bank usually starts the working process with an initial appraisal of the assets. If the result is satisfying, it will move on to negotiate the terms and conditions with the company. Then both sides will turn to their legal consultants, who are responsible for two important tasks – the due diligence check of the assets and be drawing up contracts and agreements required for the deal.
Assets are usually delineated as a separate legal entity called Special Investment Vehicle. The purpose of such entity is not to develop or grow but act as the owner of the asset. That is exactly why Special Investment Vehicles are often registered in low-tax jurisdictions such as Panama, Bermuda, or the Cayman Islands.
Once the company is able to reach some mutual agreement with the investment bank, prepare all the required documents and create a Special Investment Vehicle, a more thorough assessment will be carried out for the evaluation of the company and its assets. It is conducted by the next link in the chain – an auditor, which will provide an assessment report indicating various possible outcomes.
After that, the obligor has to go to a bond rating agency, which will review the company’s creditworthiness as well as its capacity to meet obligations. As a result, a credit rating will be given using the letter designations such as A, B, C.
Usually, the whole procedure takes 1-3 months, rarely up to 6 months. During the last stage of this process, the future bond issuer has to give commitments not to repeatedly issue bonds, alienate assets, take money from an asset by illegal acts, engage in fraudulent activities etc. meanwhile promise to retain the same CEO, give full transparency for investors and act in the best interests of them. After going through all these procedures, the company is finally ready for issuing its high-yield bond.
Evidently, a huge amount of paperwork is involved in the process. More importantly, the issuer is bounded by so many restrictions that the room for strategic maneuvers is very limited. For the investors, the level of transparency is relatively low, yet risks are high. Moreover, new issues are raised – how to oversee the condition of the asset after the bonds are issued and how to prevent possible fraud that could be carried out by asset owners?
Now there is a solution to all the above problems — the blockchain technology, which can tokenize real assets and put them on a Smart Asset Exchange, where digital tokens are traded.
Asset tokenization – a new milestone in the history of financial markets
For businesses, issuing high-yield bonds and asset tokenization have a lot in common. In essence, both activities are based on the potential payout which is backed by the company’s existing assets acting as collaterals. In order to tokenize an asset, restrictions and information disclosure obligations will also be imposed, nevertheless, more flexibility is allowed during this process.
New technologies can bring significant improvements to financial markets by making them more transparent, accessible as well as faster and simpler. At the same time, a higher level of trust between asset owners and investors will be built, too. A significant difference between tokenization and bond issuing lies in the matter of ownership. When an asset is tokenized, its ownership does not transfer to another party. Moreover, the party tokenizing an asset does not have to carry ownership of a said asset, which is extremely important and beneficial for those in jurisdictions where laws and government regulations regarding ownership are numerous and complex.
To put it simply, the process of asset tokenization can be boiled down to these three steps:
Step 1 – A real asset is assessed by the system integrator or a consulting agency to decide whether or not it can be tokenized. This step can be carried out by BANKEX and its partners.
Step 2 – Various IoT sensors or other tools are placed to monitor the asset continuously. The gathered data will be recorded on the blockchain in real time.
Step 3 – Assisted by another company, such as BANKEX, digital tokens will be issued then listed on the Smart Asset Exchange, where they can be bought by investors from all over the world.
Here I think Step 2 should be explained in more detail so the advantages of new technologies can be better understood. In this step, sensors are placed on an asset to gather data, which will be sent to the blockchain via the internet. All the concerning parties are able to monitor the condition of the asset in real time and the owner of the asset cannot distort or alter the data. This makes the assessment conducted by expensive auditors obsolete. IoT sensors can carry out audit and send data to blockchain automatically. In addition, artificial intelligence systems can also be used to analyze data and draw its own conclusions (similarly to what the bond rating agency does).
The next stage of the process resembles the previously mentioned covenants – for the asset owner to gain more trust from more investors, the data on the assets should be open to the widest range of people. You can read some Use Cases here.
As more innovation being generated, it is highly possible that there will be open pages for each token on the blockchain. Investors can leave comments and attach files as supporting evidence. If one investor finds out the asset’s owners have been withholding important information, instead of exposing it to the media or writing about it on the internet, the person can directly go to the page of the asset and address the issue there so other investors can be aware of it and start to take countermeasures accordingly.
Whistleblowers (informers) will become a part of the ecosystem. They would send out notifications of any violation of terms and agreements inside a company. Many questions would be raised due to this action, for example, how would the system operate? Are there going to be verifications of such notifications? How will they be regulated? Admittedly, the market is still finding the answers to these questions. However, with the help of the blockchain technology, our capacity of utilizing open distribution information is able to bring considerable benefits to interested parties.
Finally, it is necessary to emphasize the greatest advantage of asset tokenization – the significant reduction of costs. There will be no need to cover risks (as a rule, mythical ones caused by the data asymmetry) through higher yields. This allows the token issuer to gain more capital while the buyers can make purchases more confidently. In addition, asset tokenization can save a considerable amount of money by getting rid of the endless auditing, rating, attorney services, etc. The whole process now becomes much faster and cheaper.
To sum up, asset tokenization provides new organizational and operational solutions to expense reduction. Automatic and independent sources (IoT sensors, artificial intelligence, mobile technologies, photos etc.) that provide information on the condition of the assets boost trust amongst all parties of the deal. Open and transparent deals are now possible, even for those who did not or do not have the chance to issue their own bonds.
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